What this year's Nobel Prize winners can teach the Conservatives

Elinor Ostrom and Oliver E Williamson, the winners of the 2009 Nobel Prize in
Economics, have much to contribute to contemporary economic debate. But
their ideas should have particular resonance in the modern Conservative
party – if it actually has ambitions to liberate Britain from big government.

Williamson's work, for instance, shows why corporations grow big and vertically integrate. They do so because it is efficient: it reduces transaction costs. This helps explain why some of the privatisations in the Major era did not work. In the railway industry, for example, the track was separated from the wheel and the providers of services were not allowed to own the track. This is extremely inefficient.

Despite a huge improvement in the quality and number of services, costs on the railway have mushroomed. Perhaps the next Conservativegovernment should allow the vertical integration of railway firms once again.

A future Conservative government might also, in the light of Williamson's work, want to reflect on the policy of "contracting out" services. It might actually cost more for public sector administrators to sort out all the contractors than to do the work in-house. The solution to this problem is to place the provision of government-provided services in the private sector – wholesale – and let the market determine the most efficient way to organise things.

David Cameron should also take Ostrom to heart: her work is in many of the fields that especially interest him. Ostrom has been criticised as being against the free market because her work demonstrates how rules for governing the allocation of scarce natural resources can be developed at local level, without the intervention of government but also without the use of markets. Ostrom realises that the market is important – but she also understands the role of the non-market part of the free economy.

Her main work is on the environment. She shows how, if the government gets out of the way, communities can develop and enforce their own rules and that this leads to efficiency in an adaptable framework. The government must create conditions that allow this to happen and not look for "optimal, top-down" solutions. Ostrom's work shows how Cameron might deal with environmental problems – like the tragedy of the EU Common Fisheries Policy.

But the theme can be broadened away from Ostrom's main areas of work. What has marked out government policy over the last 25 years is the suppression of this non-market part of the free economy. For example, the Stock Exchange – a wonderful free system that provided the rules by which people traded securities without intervention by the state – was replaced in 1986 by a system of regulation on a statutory basis.

From 1997 this was replaced by wholesale government regulation. We hear daily of examples of this kind of nationalisation of the non-market sector of the free economy: the police constables prevented from looking after each others' children; the Scout Association possibly being prevented from holding international jamborees as a result of statutory child protection procedures; the recent ultimatum given by the government to the Football Association; the regulation of homeschooling, and so on.

It suits corporatist governments to ensure that all economic activity belongs firmly within the clutch of the state or in well-defined markets. Regulation and taxation are so much easier when property rights are defined in a nice neat way. Perhaps the most obvious example of how a government can appear to favour the free market and yet work against the free economy was the privatisation of the TSB in 1985. The ownership of the TSB was not well defined, but it was free and efficient, and it worked. This quirky arrangement did not suit the government so it proposed privatisation. But before it was privatised it had to be confiscated from its nebulous owners and nationalised.

Enormous courage is now needed. The government must allow the non-market part of the free economy to flourish again – and to set the rules within which the market operates. If the government is to do this it will have to take risks that there will be gaps in provision, that there will be the occasional failure, that some of the free non-market institutions will be "exclusive", and so on.

Interestingly, the Institute of Economic Affairs' (IEA) own mission statement falls into the same trap as some of the commentators on the recent laureates by implying that the free market is synonymous with the free economy. The IEA's mission is to analyse and expound the role of markets in solving economic and social problems. Given what I have written, perhaps our mission should be to analyse and expound the role of the free economy.

After all, many of my free actions and decisions relating to the use of my scarce economic resources take place without the use of markets (Prince Charles and the Archbishop of Canterbury will be pleased to know that even part of my dinner will have been grown at home). The state has intervened decisively in the last 25 years to undermine the non-market part of the free economy and we must role back the state.

If this really is Cameron's ambition, the IEA's latest Nobel Laureates can provide his intellectual framework.

Philip Booth is editorial and programme director of the Institute of Economic Affairs